US Office S-REITs - Are We There (Near Bottom) Yet?
- The US Office S-REITs have been one of the biggest ‘casualties’ among the S-REITs with share prices have declined 35% to 49% year-to-date. Manulife US REIT's share price and Prime US REIT's share price are now 39% and 10% below that of Mar 20 (COVID) low while Keppel Pacific Oak US REIT's share price is still 32% above Mar 20 (COVID) low. See summary of S-REIT's share price performance.
- The US Office REIT were not spared either having declined 41% year-to-date (gateway office REITs -41% year-to-date; regional office REITs -40% year-to-date).
Down but not out – some potential earnings risk but there are mitigating factors that could offset some earnings risks.
- Potential vacancy risks: While headline yields are looking very attractive at above 10% yield, we believe the operational environment will likely remain volatile in the near-term given a few factors below:
- The return-to-office has been slower than expected with physical occupancy averaging at ~50%.
- The adoption and impact from hybrid working is larger than expected
- US companies are in a stage of reviewing their office space needs
- In addition, with heightened fears of recession, potential rationalization of staff force could further spur potential downsizing of office space. While we have started to hear pockets of staff lay-offs, the low unemployment rates and strong non-farm payrolls data is still supportive the US employment situation.
- As such this may pose some potential earnings risk on the US Office S-REITs with potential higher vacancies. Some known larger vacancies to-date in Manulife US REIT’s and Prime US REIT’s portfolio could have driven the underperformance in share price compared to Keppel Pacific Oak US REIT.
- Manulife US REIT:
- TCW Group (contributes 3.8% of gross rental income “GRI”) will be vacating to avoid major renovation;
- Quinn Emanuel (contributes 2.9% of GRI) almost halved its office space from Aug22 but extended its lease by 5.4 years from Sep23;
- Flex by JLL of a total of 36k sqft (0.7% of portfolio NLA) will likely go through a period of renovations with phase 1 expected to complete in Apr23 while phase 2 and 3 by 2023.
- In summary, we estimate that this could possibly be 6% to 7% of potential vacancy / temporary loss of rental income in the near-term.
- Prime US REIT:
- Whitney, Bradley & Brown (contributes 2.6% of cash rental income “CRI”) will be vacating in 3Q22 to consolidate into its acquirer company, WeWork’s termination fee will be ending in Nov22 (previously contributes 2.5% of CRI). While Prime US REIT will be backfilling two of three floors soon, we expect rental income contribution could be delayed.
- In summary, we estimate potential ~5% of potential vacancy / temporary loss of income in the near-term.
- Manulife US REIT:
- While there may be some downside risks, there are also some bright spots for the US Office S-REITs that could mitigate some of the vacancy risks.
- Office tours have increased post-COVID and leasing activities have picked up.
- While companies are rationalizing their office space needs, companies may look to consolidate their office in better quality and well-located office buildings. As such, good quality office buildings at well-sought after locations will be more resilient.
- US Office S-REITs typically have longer WALE at 4 to 5 years with minimal lease expiries remaining in FY22 and FY23 lease expiries ranges between 10% to 17%.
Sharp increase in US interest rates, partially mitigated by high hedging ratio of above 80%.
- The hawkish Fed rate hikes throughout the year has caused US interest rates to rise; the US 5-year swap rate is ~4.2%. While the US Office S-REITs have high hedging ratio of above 80% that will mitigate interest expense impact from floating interest rates, refinancing risks remain especially for FY23 when high interest rate environment could stay for longer than expected.
- The US Office S-REITs average cost of debt is currently at ~3% with term to maturity ranges from 2.7 years to 3.3 years. Debt expiring in FY23 ranges from 11% to 31%.
- Based on our ballpark estimate, if we raised floating rates to 5.15% and interest rates for FY23F refinancing, the full-year impact to DPU is ~6% to 9%.
Convert management fees to cash.
- With the massive decline in share prices, the US Office S-REITs are now trading at an average of below 0.6x P/B. Given the deep discount to book, we believe that management may consider paying management fees in cash rather than units to reduce further dilution to NAV.
- In 2Q2022, Keppel Pacific Oak US REIT changed the policy to pay 100% of its management fees in cash from units previously. While Manulife US REIT and Prime US REIT have not expressed that they may follow suit, they may now consider the conversion if share price were to remain in deep discount to NAV for longer.
Are headwinds priced in for US Office S-REITs?
- At these depressed levels of share prices, the question to ask now would be – how much of these known potential headwinds are priced in? Are US Office S-REITs' valuations at an attractive level?
- We did a sensitivity analysis pricing in potential earnings risks as highlighted in the segment above. At current share price levels, we believe that the US Office S-REITs have priced in the majority of the known downside risks for now.
- While the negative macro economic conditions may continue to weigh down the share prices, we do not rule out that there could be short-term rallies with potential relief of overhang on these over-sold share prices.
- In our sensitivity analysis, potential earnings risk adjustment to our forecast includes:
- Scenario 1: Revenue and NPI decline by 10%, Average cost of debt increased to 5% from current 3%, 100% of management fees are paid in cash.
- Scenario 2: Revenue and NPI decline by 20%, Average cost of debt increased to 5% from current 3%, 100% of management fees are paid in cash.
- While it is arguable what is fair value yields should be given the negative macro economic outlook, at 8% to 10% yield, the US Office S-REITs would have priced in a DPU decline of 30% to 39% led by 10% decline in NPI, average cost of debt of 5% and management fees paid in cash.
- Based on average historical yield of 6% to 8%, the US Office S-REITs have priced a DPU decline of 45% to 52% led by 20% decline in NPI and similar adjustments to average cost of and management fees. See Keppel Pacific Oak US REIT's Dividend History, Manulife US REIT's Dividend History, Prime US REIT's Dividend History.
- Macro economic concerns may delay potential recovery but we do not rule out short-term rallies with any positive news. Prefer Keppel Pacific Oak US REIT but Manulife US REIT and Prime US REIT valuations are compelling.
Above is the excerpt from report by DBS Group Research.
Clients of DBS may access the full report in PDF @ https://www.dbs.com/insightsdirect/.
Rachel TAN DBS Group Research | Derek TAN DBS Research | https://www.dbs.com/insightsdirect/ 2022-10-19 2022-10-19
Read also DBS Research's most recent report:
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